Looking to buy or lease a facility for your business? Take a look at the 1st Quarter National report for the US.

National Market Report (1)

Looking to buy or lease a facility for your business? Take a look at the 1st Quarter National report for the US.


After more than two years of massive uncertainty, the “hybrid” work arrangement — in which employees spend two to three days per week working remotely — has
emerged as the preferred model for a plurality of office using tenants, especially in the technology, finance, and professional services sectors. This has resulted in a downshift in demand for office space, which in turn has produced a flood of availability on the sublease market. At a high level, absorption has decoupled from employment growth, with the limited remaining demand concentrated on recently constructed buildings, which are better able to accommodate contemporary workplace requirements. Now, just as the industry has begun to adjust to these normal-for-now conditions, new headwinds are emerging in the form of recession fears. Many economists are now forecasting a mild recession in early 2023, which will add a cyclical dynamic to the structural changes wrought by hybrid work. While employment growth has remained strong throughout 2022 so far, the persistence of inflation and its permeation into most product and service categories has led the Federal Reserve toward a sustained policy of raising interest rates. This has many companies planning for layoffs, with some in the once space-hungry technology sector near the top of the list. The outlook is further complicated by nearly 60 million SF of new supply projected to come online by the end of 23Q1. Together, these factors are weighing on rent growth, which has trailed far behind inflation since the beginning of 2021 — even without accounting for the more aggressive concession packages landlords are offering tenants to preserve occupancy. Transaction activity has fallen precipitously from the elevated levels seen in 2021 but has held up relatively well through Q3 compared to the five-year period that preceded the pandemic. Even so, the slowdown in sales volume could be abrupt. Higher financing costs and weak fundamentals are likely to create a bid/ask spread in the short term that puts the brakes on transactions until other factors — such as distress — generate sales that reset the market. In short, the commercial office market faces pressure from multiple directions as the end of 2022 approaches. There are bright spots in certain secondary and Sun Belt markets, as well as in niche sectors like major life sciences clusters. But overall, the sector faces strong challenges in realizing the highest and best uses for its assets.


After rebounding in the second half of 2021 and early 2022, the leasing market has softened again in recent months. The structural shift in demand resulting from hybrid work arrangements contributed to a contraction in occupied space during 22Q3, making it two consecutive quarters — and seven of the past 10 — of negative net absorption. This pushed vacancy up to a near-record 12.5 percent, the highest level recorded since the Great Recession more than a decade ago. With the prospect of a new recession on the horizon, the market has not yet bottomed out. Our current baseline forecast calls for vacancy to reach an unprecedented 13.6% by the beginning of 2024. Nowhere is weakness in the sector more evident than in the sublease market. There were more than 230 million SF available for sublease at the end of 22Q3, an increase of 90% from the end of 2019. The impact is particularly acute in some markets. San Francisco alone has nearly 10.5 million SF available for sublease, which represents 5.5% of inventory. Similarly, New York has nearly 30 million SF of sublease availability, representing 3% of inventory. Given the flood of sublease inventory onto the market, the availability rate is a better indicator than the vacancy rate of the true state of play. Overall availability reached 16% in 22Q3, nearly matching the record high that coincided with vacancy’s peak in 2010. Sublease space has combined with recent deliveries, which tend to enter at the top end of the market, to availability even higher at 4 & 5 Star properties, where it now exceeds 22%. Despite this gloomy backdrop, demand has held up relatively well in some segments of the market. At recent-vintage properties — those completed since 2010 — net absorption has been positive each quarter, even during the height of the pandemic. Since the beginning of 2020, these properties have seen an average of 20 million SF of positive net absorption per quarter. While this is down about 25% from the quarterly average in 2017–19, newer properties have nevertheless performed dramatically better than older ones. In other cases, local market dynamics have propped up demand for office space. Vacancy is lower now than it was entering 2020 in Las Vegas and the Inland Empire. And while it has increased in Boston, demand for lab space in the red-hot life sciences sector has helped the market weather conditions well compared to other gateway cities. The overall outlook for office leasing, however, remains challenging. The prospect of a wave of layoffs, which has already begun in the technology sector, will do nothing to stimulate demand for office space. Generally weak conditions are thus likely to persist for some time.


Office rent performance has been poor since the initial shock of COVID-19. Market rents dipped as tenants shed space throughout 2020 and into 2021, then began to recover somewhat, though outsized sublease availability has put downward pressure on growth. At just over $35 per SF, the national average rent is on par with what it was entering the pandemic. At 4 & 5 Star properties, however, the average rent is down nearly $1 per SF, to $45.43, narrowing the quality premium by over 200 basis points. The current economic context of elevated inflation is an important factor in evaluating office rent growth, particularly relative to other commercial property types. In the five years prior to the pandemic, rents in the office, retail, and multifamily sectors generally grew at a year- over-year rate of 2%-3%, slightly above inflation as measured by the Consumer Price Index (CPI). Industrial rents grew at over 5% during the same period. Since 2020, industrial rent growth has maintained roughly the same spread above inflation. Multifamily rents initially advanced at rates far exceeding inflation, though they have recently cooled substantially. Retail rents have not kept consistent pace with inflation, but growth has approached 5% in recent quarters and appears to be converging with a moderating CPI. The office sector is the clear outlier. Nominal rents are essentially flat since the end of 2019; meanwhile, inflation has stayed well above 7% throughout 2022, reaching as high as 9% in the middle of the year. Thus, real market rents have been in steady decline. Even in nominal terms, marginal growth in asking rents masks the reality currently facing landlords. Players in the market are reporting generous concession packages, including longer periods of free rent and higher tenant improvement allowances intended to attract tenants and help them adapt to rising build-out costs. In this environment, effective rents are almost certainly falling for most properties in most markets.


On the supply side, over 31 million SF of net new inventory was delivered in the first three quarters of 2022, with another 12.4 million projected by the end of the year. This is down 30% from the same period in 2021 but still in line with the long-term average. Construction starts have slowed more quickly. From the beginning of 2014 through 20Q1, starts averaged 20.8 million SF per quarter. Since then, the quarterly average has fallen to 14.9 million, a 28% decline that will help to constrain future supply. With tighter financing conditions and general economic headwinds now facing developers, construction activity should slow further. Still, there are nearly 145 million SF currently under development, including 55.5 million SF projected to be delivered by the end of 23Q1. Over 35% of this pipeline remains unleased, which will add to the glut of high-quality space from which a smaller number of tenants in the market will be able to choose. As would be expected, much of this pipeline is concentrated in markets where demand has so far been comparatively resilient. Together, San Jose and Seattle have over 20 million SF in the pipeline, putting them at particular risk given the employment outlook in the key technology sector. Life sciences hubs Boston and San Diego also have relatively large development pipelines, as do Sun Belt metros such as Austin, Nashville, Miami, and Charlotte. Gateway cities New York, Washington, D.C., and Los Angeles remain perennial leaders in construction activity, though the volume is well within the typical range in each. The overall picture is one of steady supply growth in line with historical trends, a pattern that would have been unremarkable before 2020. On the one hand, this offers another indication that softness in the leasing market is primarily a demand-side phenomenon. On the other hand, it also suggests that development activity has not yet moderated sufficiently to adapt to the change.


The second half of 2021 saw exceptionally high sales volumes across commercial real estate sectors, including office. Quarterly volumes have fallen in 2022, but only back to a level near what was typical in the five years leading up to 2020. Estimated sales for the first three quarters of 2022 totaled nearly $110 billion, about the same as the same period in 2019. Pricing, too, has held up relatively well, climbing to an average of $337 per SF at the end of 22Q3, at a market capitalization rate of just under 7%, about 10 basis points below the average at the beginning of 2020. These figures, though, do not necessarily reflect the on- the-ground reality for many prospective buyers and sellers as the end of the year approaches. Most sales that have closed to this point in the year would have been in the works months before the full impact of rising interest rates and economic headwinds became apparent. These factors, combined with softening fundamentals resulting from broad adoption of hybrid work arrangements, are weighing on valuations and widening bid/ask spreads. Thus, a significant slowdown in transaction activity is likely in the coming months, with buyers looking for discounts and sellers unwilling to budge unless and until they must. Capital to invest in real estate is still abundant, but with lenders cooling on the office sector, much of it will move to the sidelines or be deployed at other types of commercial property until a repricing occurs. There are already signals that such a repricing could be imminent. The market capitalization of public office REITs would indicate that values have fallen approximately 35%, with a corresponding rise in cap rates of 200 basis points — though it should be noted that the portfolios owned by these firms are not generally representative of the larger market. Speaking privately, industry insiders suggest a downward adjustment of 20% or more is inevitable. Several factors could combine to realize a correction during 2023. Many properties will face elevated lease rollover risk in the coming year, with organic long-term leases expiring alongside short-term extensions executed during the pandemic. Given the conditions prevailing in the leasing market, renewal rates are likely to be lower than historical norms would suggest, especially at older properties. Furthermore, even those borrowers able to find lenders will be facing higher interest rates and tighter underwriting standards. A wave of loans maturing amidst weak fundamentals and a difficult borrowing environment could trigger distressed transactions and reset the market, presenting opportunities to all-cash buyers and other well- capitalized investors.


The odds of the economy falling into recession are climbing, as the Federal Reserve boosts interest rates sharply to rein in inflation that is stubbornly lingering at a decades-high rate. As a result, consumer sentiment has plunged and threatens to derail consumer spending that supports roughly two-thirds of the economy. Pandemic-related shortages of material and labor and persistent snags in supply chains have caused prices to vault higher for months. Inflation as measured by the consumer price index (CPI) accelerated to 9.1% over the year in June, its fastest pace in over four decades. The index has eased somewhat since then, slowing to 7.7% in October, mostly due to the falling price of gasoline, suggesting that peak inflation was reached in June. However, core CPI, which excludes food and energy prices, has been slower to retreat, with broad-based gains continuing across many products and services. In response to rising prices, the Federal Reserve is engaging in an aggressive tightening program, having already raised its policy rate by 375 basis points since March, including unusually large increases of 75 basis points at its last four FOMC meetings. The central bank is also shrinking its bloated balance sheet. Beginning in September, almost $100 billion of assets have been allowed to mature without reinvestment, shrinking the monetary base. Federal Reserve Chairman Jerome Powell has repeatedly stressed that the committee is focused on its price stability mandate and will push rates higher until inflation is brought down, even at the risk of triggering job losses and an economic slowdown. Rising prices and recession fears have weighed heavily on consumer sentiment and are evidently leading to demand destruction. Consumer spending was supported by stimulus payments that were sent to households during the pandemic but has been slowing since the beginning of the year. The anticipated rotation in spending away from durable goods such as automobiles and furniture to services such as restaurant meals and hotel stays has been slower than expected. Inflation- adjusted spending on durable goods rose by a mere 0.1% in September, while spending on nondurable goods grew by 0.6%. Meanwhile, spending on services rose by only 0.3%, with transportation services and spending at hotels and restaurants growing the fastest. Economic momentum had already flagged in the first half of 2022, which saw two quarters of negative economic growth, often seen as the definition of a recession. However, gross domestic product popped higher by 2.6% in the third quarter, more than expected, as net exports boosted economic growth. However, with demand continuing to cool and net exports expected to decline, most analysts have downgraded their forecasts, expecting the economy to slow to a standstill in 2022 or turn negative for the year overall. But the labor market is still tight. An average of 562,000 jobs were added every month in 2021, and more than 4 million have been added so far in 2022. The unemployment rate in October was 3.7%, still close to its pre-pandemic level. Labor participation remains somewhat weak and is still below pre-pandemic levels as workers continue to cite COVID fears and a lack of childcare options as reasons to remain on the sidelines. With 10.7 million job openings recorded on the last day
of September, down from an earlier high but still representing almost two job vacancies for each unemployed worker, competition for workers is driving wages higher, but inflation is eroding household incomes. Personal income grew by 0.4% in September for the third consecutive month, and the personal savings rate fell to 3.1%, as spending outpaces incomes and households dip into savings accounts. Other recent data confirm a slowdown in activity. Announcements of hiring freezes and impending layoffs are widespread, suggesting that the labor market will slow in coming days. Business investment is at risk as factories report new orders for their products are slowing. And with mortgage rates rising to levels not seen in years and housing prices still uncomfortably high, affordability has eroded, leading to a sharp turnaround in what had been a red-hot housing market. Sales of both new and existing homes have fallen in recent months as potential homebuyers are being priced out of the market.

/ Commercial Real Estate

About the Author

Lynn Drake’s status is well known in the industry: She’s the commercial realtor focused on maintaining “true north” for her corporate clients. It’s a reputation built on 35 years of commercial real estate experience. Lynn became a commercial realtor in 2001 after 15 years in corporate real estate. Thus far in her career, Lynn has successfully completed over 1,500 real estate transactions ranging from small business tenant leases to the sale and purchase of industrial complexes.